The small business start up kit a step by step legal guide, 6 edition

All you need to know about startup, including: • Create a solid business plan• Get the right permits and licenses• Comply with tax rules

Peri H Pakroo, J.D.,

author of Starting & Building a Nonprofit

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Start-Up Kit

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The

Small Business

Start-Up Kit

By Peri H Pakroo Edited by Marcia Stewart

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to practice in your state

many thanks to beth laurence, for her sharp editing as well as her ment and understanding as i finished the first edition of this book in the middle

encourage-of a cross-country move thanks also to Jake warner for his helpful input and suggestions, and his unwaverable sparkling energy thanks are also due to Janet portman for her review of the material on commercial leases; patti gima and Steve Elias for lending their expertise in domain names and trademark law; and James Judd for assistance with the information on internet sales taxes as always, i was helped immensely by the support of all the nolo editors, and i will miss all of you

thanks also to terri Hearsh for making the information in this book clear and attractive, as well as to Ely newman and andré Zivkovich for creating the forms cD-rOm and a big thank you goes to the nolo marketing folks for their smart and creative style in getting the word out about this book

without my partner in crime this last year might have squashed me Showers

of thanks and love to turtle

—pHp 2000

Dedication

i dedicate this book to my grandmother Eunice michaelson Jones—a spitfire if ever there was one

peri pakroo is a consultant and media developer, specializing in legal and

start-up issues for businesses and nonprofits She owns and runs p-brain media (www.pbrainmedia.com), a strategic consulting and communications firm that develops information-rich media for web, print, video, and other formats She received her law degree from the university of new mexico School of law in 1995, and a year later began editing and writing for nolo, specializing

in small business and intellectual property issues She is the author of The Small Business Start-Up Kit (national and california editions) and Starting and Building a Nonprofit , and has edited such titles as nolo’s Starting & Running

a Successful Newsletter or Magazine ; Getting Permission: How to License & Clear Copyrighted Materials Online & Off ; Music Law ; and How to Write a Business Plan peri teaches adult education courses at wESSt (www.wesst.org)

in albuquerque, a nonprofit whose mission is to fight poverty by facilitating entrepreneurship among women and minorities in the state of new mexico She

is active in supporting local, independent businesses and is a co-founder of the albuquerque independent business alliance

The printed version of this book comes with a CD-ROM that contains legal forms and other material You can download that material by going

of the forms, which you can fill in or modify and then print.

Your Small Business Start-Up Companion 1

1 Choosing a Legal Structure 7

Sole Proprietorships 9

Partnerships 12

Limited Liability Companies (LLCs) 18

Corporations 21

Choosing the Best Structure for Your Business .26

2 Picking a Winning Business Name .29

An Overview of Trademark Law 30

Trademark Issues Online 38

Name Searches 42

Choosing a Domain Name 46

Trademark Registration 47

Winning Names for Your Business, Products, and Services 47

3 Choosing a Business Location .51

Picking the Right Spot 52

Complying With Zoning Laws 55

Commercial Leases 59

4 Drafting an Effective Business Plan .61

Different Purposes Require Different Plans 62

Describing Your Business and Yourself 63

Making Financial Projections 68

Break-Even Analysis 70

Profit/Loss Forecast 79

Start-Up Cost Estimate 82

Cash Flow Projection 83

Putting It All Together 87

Using Your Plan to Raise Start-Up Money 88

Pricing and Billing for Service Businesses 94

Bidding and Creating Proposals 98

Pricing for Businesses Selling Products 101

6 Federal, State, and Local Start-Up Requirements .105

Step 1: File Organizational Documents With Your State (Corporations, LLCs, and Limited Partnerships Only) 107

Step 2: Obtain a Federal Employer Identification Number 108

Step 3: Register Your Fictitious Business Name .110

Step 4: Obtain a Local Tax Registration Certificate 114

Step 5: Obtain a State Seller’s Permit 116

Step 6: Obtain Specialized Licenses or Permits 116

7 Risk Management .119

Who Might Sue or Be Sued 120

Risk Management Strategies 126

Insurance and Warranties 129

8 Paying Your Taxes 137

Tax Basics 138

Income Taxes for Sole Proprietors 144

Income Taxes for Partnerships 146

Income Taxes for LLCs 148

Estimating and Paying Your Taxes Quarterly 149

City and County Taxes 152

Sales Taxes 153

9 Laws, Taxes, and Other Issues for Home Businesses 159

Zoning Restrictions 160

The Home Business Tax Deduction 162

Risks and Insurance 167

10 Entering Into Contracts and Agreements 171

Contract Basics 172

Using Standard Contracts 176

Electronic Contracts 182

11 Bookkeeping, Accounting, and Financial Management 187

Accounting Basics 189

Cash vs Accrual Accounting 192

Step 1: Keeping and Organizing Receipts 194

Step 2: Entering Receipts Into Bookkeeping Software 196

Step 3: Generating Financial Reports 199

12 Small Business Marketing 101 .209

Defining Your Market 210

Learning About Your Market: Market Research 215

Cost-Effective Marketing Tools 219

13 E-Business: Selling and Marketing Online .227

Defining Your Strategy and Goals 229

A Website: Your Online Base Camp 232

Online Outreach Methods 233

E-Commerce: What’s Involved? 237

Website Builder Services and Affiliate Stores: Do or Don’t? 238

Planning a Website Project 239

Choosing and Working With a Web Developer 244

Creating a Website 247

Domain Names and Hosting 255

Intellectual Property: Who Owns Your Website? 256

14 Planning for Changes in Ownership 261

When You Need a Written Agreement 262

Buy-Sell Agreement Basics 264

Limiting Ownership Transfers 265

Forcing Buyouts 265

Establishing the Price for Sales 267

Implementing Buy-Sell Provisions 268

Sample Buy-Sell Provisions 269

Employees vs Independent Contractors 280

Special Hurdles for Employers 282

Hiring and Managing Staff 284

16 Getting Professional Help .287

Working With Lawyers 288

Working With Accountants and Other Financial Professionals .291

Internet Legal Research .292

Appendixes A Small Business Resources and State-by-State Contact Information .295

Small Business Start-Up Information 297

State Tax Agencies 299

State Sales Tax or Seller’s Permit Agencies 301

LLC Offices 303

State Unemployment Compensation Agencies 305

B How to Use the Forms CD-ROM .307

Installing the Files Onto Your Computer 308

Using the Word Processing Files to Create Documents 308

Using Government Forms 310

Using the Spreadsheets 310

Opening a File 311

Files on the CD-ROM* 312

*The following spreadsheets are available only on the CD-ROM:

Cash Flow Projection Worksheet

Profit/Loss Forecast Worksheet

Break-Even Analysis Worksheet

Billable Rate Worksheet

Warranty Track Worksheet

Partnership Agreement

Application for Employer Identification Number (IRS Form SS-4)

Instructions for Form SS-4

Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding (IRS Form SS-8)

Election To Have a Tax Year Other Than a Required Tax Year (IRS Form 8716) Entity Classification Election (IRS Form 8832)

Index .339

You don’t have an mba Hell, you’ve never

taken a business class you spent your

college years studying literature and art

history, and periodically dropping out to travel the

world and now you find yourself thinking about

going into business for yourself—maybe restoring

antiques, illustrating books, running a café, or selling

software “me, a businessperson?” you skeptically

wonder you keep trudging to work each morning,

but as the hours tick by you find yourself fantasizing

more and more about kissing your 9-to-5 job

goodbye you jot down some notes, work out some

kinks in your plan and continue to wonder whether

it just might fly…

unfortunately, most people who have toyed

with business ideas this way never get to find out

whether they would have worked or not for a

variety of practical, financial, and psychological

reasons, most folks just don’t take the leap from

idea to reality this is really a shame, since there’s

nothing that complex or difficult about turning a

business idea into an actual working business most

prospective entrepreneurs would be surprised—and

encouraged—to know that they can get most of the

way across the line between “i’m thinking about

starting my own business” and “i own and run my

own business!” simply by completing a short list of

bureaucratic tasks this book will explain what those

tasks are and how to complete them

Stephen Parr, owner and director of Oddball

Film and Video, a stock film and video footage

company in San Francisco, California:

I started making video art in the 1970s After

a while I started collecting all these weird bits

of film because it was cheaper than shooting it

myself I gathered all kinds of old, found footage,

like military training films, educational films,

home movies, and all kinds of other images,

and put them together into montages, which I

screened in nightclubs as background visuals I

was showing them all over—nightclubs in New

York, Chicago, San Francisco—and I made

some money by selling the tapes to the clubs.

Then I started getting calls from companies

in Silicon Valley that produce industrial videos, like training films and promotional programs for corporate trade shows Video game companies were calling, too Companies like Sega, Sun Microsystems, and Silicon Graphics wanted to pay me for my footage Friends thought I should

go into business selling the stock footage I had collected, but I didn’t know if I could make a living doing it I didn’t know anything about the stock footage business There were a few companies doing it, but they were in New York

or LA, and they seemed really huge.

But since I liked working with images and since the business had already started to take off

on its own, I decided to formalize it I wanted an interesting company name that conveyed what

I did We came up with Oddball It’s a word that people don’t really use anymore, more of a ’40s

or ’50s expression—an oddball is someone kind

of weird, unbalanced, or unusual, you know?

At the most basic level, my business involves finding, organizing, and preserving historical footage And then distributing it Our clients include ad agencies; news organizations; docu- mentary and feature filmmakers; industrial, corporate, and music video producers; edu- cational filmmakers; and anyone who needs offbeat and unusual images In one way, we’re like a library: We archive and license historical visual information.

These days, I spend most of my time trying

to organize and publicize my business We just launched our website, and that takes time to maintain And I spend a lot more time trying to obtain films than actually looking at them Still, what I do at Oddball is an extension of the work I’ve been doing since the 1970s I guess it became

a business the day I decided I wasn’t going to do anything else.

you undoubtedly already know that getting a business off the ground isn’t easy you’ve got a

million different details to work out—how you’ll

produce your product or service, how much you’ll

charge, what marketing strategies to use, how to

manage your cash flow—and you need to nail all of

this down before you stand to make a dime you’ll

likely find that very few, if any, other businesspeople

have done exactly what you’re setting out to do, so

you’ll have to answer a lot of questions on your own

(or with your partners) it can be scary and lonely—

and while exhilarating, it’s almost always stressful

but compared to working out the details of

how your business will run and become successful,

clearing the bureaucratic hurdles isn’t a big deal at

all Dealing with governmental start-up requirements

has been done millions of times before by all types

of different businesses though the bureaucracy

governing small business often seems like a

convoluted maze, you can take comfort in the fact

that the procedures are standard—they apply more

or less the same to everybody the answers are

out there unlike your unique business strategy

that you’ll need your best creative wits to devise,

conquering the bureaucracy is essentially a

no-brainer yes, it requires some patience and fortitude,

but by no means do you need any special skill,

education, or experience as long as you do a bit of

homework and arm yourself with an overview of the

process (as you’re doing by reading this book), you’ll

be able to meet all the small business registration

requirements without breaking a sweat

you can usually start a sole proprietorship

(the legal term for a one-owner business) or a

partnership (a business with more than one owner)

by registering with just one government office and

for business owners who want protection from

personal liability for business debts—often referred

to by the legal jargon “limited liability”—the simplest

corporations or limited liability companies (llcs)

require only a couple more registration tasks to

complete in other words, once you’ve got your

business idea developed to a certain degree, all you

need to do is visit a few government offices, fill out

some forms, and pay some fees—and suddenly your

idea will have become an actual, legitimate business

Keep in mind that there’s certainly a lot more to

launching a successful small business than dealing

with bureaucratic requirements for starters, you’ll

need to have a sound business idea, and you’ll need

to be able to develop good management skills to guide it to success this book, however, largely leaves these issues for other resources to cover unlike many other small business guides, we’re not going to spend your precious time quizzing you on whether you have the right personality to be your own boss, evaluating your business idea, or helping you to identify the personal goals that you hope to achieve by starting a business if you need more help deciding whether or not to start a business or what kind of business you should start, you should probably buy a different book if, on the other hand, you want a book that cuts to the chase and explains systematically what you need to do to launch a business officially and legally, this book is for you this book is also for those of you who are fairly certain you want to give your idea a try, but not quite ready to march down to city hall to register your business in addition to explaining the start-up requirements that apply to most small businesses, this book also outlines the preliminary work you should

do before heading out to file all your official forms chapters 1 through 4 discuss fundamental tasks such

as choosing the right legal structure for your business (sole proprietorship, partnership, llc, or corporation), coming up with a catchy and legally sound business name, and finding a location that’s good for business

we also explain how to draft a business plan that will help you define your business, plan for profitability, and attract lenders and investors if you’ve already taken care of some of these tasks, you can either skip these chapters or use them as a guide to evaluate what you’ve already done

to help you all the way through your start-up days, later chapters introduce you to a number of basic issues facing every ongoing business these include insurance, taxes, contracts and agreements, marketing (including taking your business online), and bookkeeping, accounting, and financial management (with cash flow projection and other useful worksheets included on the cD-rOm that comes with this book) though they’re not exactly start-up requirements, they’re important to understand in the dawning days of your business

so that you’ll be able to handle them later when business is fast and furious

finally, keep in mind that businesses with

employees have significant additional responsibilities

chapter 15 offers a general overview of the laws and

regulations that govern businesses with employees

if you’re thinking about hiring employees, that

chapter will help you figure out if you’re ready to

tackle the many requirements that come with your

first hire chapter 15 also explains the difference

between employees and independent contractors—

an important distinction, because using independent

contractors does not subject you to most of the

laws that apply when you hire employees if you

decide that you need to hire any employees, you’ll

probably need to do further reading an excellent

and exhaustive resource is The Employer’s Legal

Handbook, by fred S Steingold (nolo)

One of the main ideas to take away from this

book is that there’s nothing mysterious or even

terribly complex about the process of starting your

own business whether you’ve drafted a highly

specific business plan with the help of accountants

and consultants or you’ve scratched it out on a

cocktail napkin, the process of turning that idea into

a legitimate business is the same that process is

covered in this book

How you build and run your business, on the other hand, is where the real challenge comes in you’ll need confidence to get your business rolling—and you’ll need guts, too you may well find that some of the questions burning in your mind have

no defined answer, because no one has asked that question or tried that idea before you probably wanted to start a business in the first place so that you could make your own decisions—but this can often be quite a heavy burden you may not believe

it now, but some days you’ll probably find yourself wishing you had a boss

you’ll need to learn to trust yourself, both when you feel optimistic and when you suspect that one

of your ideas is less than brilliant you’ll also have to develop a sense for when you need help and learn

to be judicious in taking the advice of people around you part of the art of controlling your own destiny

is accepting the wisdom of others while maintaining your own focus and direction it’s not always an easy balance to maintain, but you’ll undoubtedly get better at it as you gain experience in running your own show the bottom line: think hard, keep your mind open—and fight like hell to make your ideas a reality

take the leap

More Small Business Products from Nolo

Nolo’s website (www.nolo.com) offers books,

software, online legal forms, eProducts and

free legal information to help businesses solve

specific legal problems Here are some of the most

popular business titles You’ll find more online

Business Plans

Business Plan Pro 2009

by Palo Alto Software (available through Nolo)

A fast, easy way to generate the plan you need to

launch or expand your business

How to Write a Business Plan

by Mike McKeever

Explains how to write a business plan, whether

for your own purposes or to attract money from

lenders or investors—including how to evaluate the

profitability of your business idea; estimate operating

expenses; determine assets, liabilities, and net worth;

and find potential sources of financing

Business Operations

Negotiate the Best Lease for Your Business

by Janet Portman and Fred S Steingold

A guide to the ins and outs of finding a space for

your business, negotiating a lease, and solving

problems that arise from it

Legal Forms for Starting & Running a Small Business

by Fred S Steingold

Dozens of legal forms and documents crucial for the

success of a small business

Legal Guide for Starting & Running a Small Business

by Fred S Steingold

All the legal info you need to get your business off

the ground and running—including how to raise

start-up money, attract the best help, buy or sell a

business or franchise, negotiate a favorable lease,

insure your business, and resolve legal disputes

Quicken Legal Business Pro 2010

by Nolo

A software package containing more than 140 legal forms and the complete text of five of Nolo’s

bestselling business titles—including Legal Guide

for Starting & Running a Small Business, Tax Savvy for Small Business, The Manager’s Legal Handbook, How to Write a Business Plan, and Marketing Without Advertising.

Running a Side Business:

How to Create a Second Income

by Richard Stim and Lisa Guerin

Have the drive but need the “know-how” to start and run a side business (while working full time)? Find answers to your business questions in this book

Save Your Small Business: 10 Crucial Strategies to Survive Hard Times or Close Down and Move On

by Ralph Warner and Bethany K Laurence

Packed with the ideas, strategies, and lessons that have kept a successful entrepreneur in business for more than 30 years

Forms of Ownership

Business Buyout Agreements:

A Step-by-Step Guide for Co-Owners

by Anthony Mancuso and Bethany K Laurence

Explains how to protect your business interests

by drawing up a “premarital” agreement between you and your business owners that sets out a plan for what happens if you or a co-owner leaves the company A must for any new business with more than one owner

Form Your Own Limited Liability Company

by Anthony Mancuso

Offers instructions and forms to create an LLC in your state, as well as a full explanation of LLCs and how they work

More Small Business Products from Nolo (continued)

Incorporate Your Business: A Legal Guide to

Forming a Corporation in Your State

by Anthony Mancuso

Ready to incorporate your business? This

do-it-yourself guide provides everything you need to get

the job done—without a lawyer

LLC Maker

by Anthony Mancuso

Windows software that assembles LLC articles of

organization according to state legal requirements,

plus an operating agreement and other LLC

formation paperwork

Nolo’s Quick LLC: All You Need to Know

About Limited Liability Companies

by Anthony Mancuso

Explains the basics of limited liability companies,

and helps you figure out whether structuring your

business as an LLC is the right way to go

Form a Partnership: The Complete Legal Guide

by Denis Clifford and Ralph Warner

Describes the legal and practical issues of creating a

partnership—including financial and tax liabilities,

contributions and distributions, and changes in

ownership

Intellectual Property

Trademark: Legal Care for Your

Business & Product Name

by Stephen R Elias and Richard Stim

The information and forms you need to choose a

distinctive trademark, register it, and fight infringers

Marketing

Marketing Without Advertising: Easy Ways to Build

a Business Your Customers Will Love & Recommend

by Michael Phillips and Salli Rasberry

Explains the secret of attracting customers

without pricey ads—including how to build trust

with potential customers, encourage customer recommendations, improve customer service, list products and services widely and inexpensively, and use the Internet to market services and products

Home Business Tax Deductions: Keep What You Earn

The Manager’s Legal Handbook

by Lisa Guerin and Amy DelPo

A quick reference to employment law, combining legal information and practical ideas

Working With Independent Contractors

by Stephen Fishman

Explains all the tricky IRS rules and provides forms and instructions for hiring independent contractors

Sole Proprietorships 9

Pass-Through Taxation 9

Personal Liability for Business Debts 11

Creating a Sole Proprietorship 12

Limited Liability Companies (LLCs) 18

Limited Personal Liability 18

Forming and Running a Corporation 25

Choosing the Best Structure for Your Business 26

You probably already have a rough idea of

the type of legal structure your business

will take, whether you know it or not that’s

because, in large part, the ownership structure

that’s right for your business—a sole proprietorship,

partnership, llc, or corporation—depends on how

many people will own the business and what type

of services or products it will provide, things you’ve

undoubtedly thought about quite a bit

for instance, if you know that you will be the

only owner, then a partnership is obviously not

your thing (a partnership by definition has more

than one owner.) and if your business will engage

in risky activities (for example, trading stocks

or repairing roofs), you’ll want not only to buy

insurance, but also to consider forming an entity that

provides personal liability protection (a corporation

or a limited liability company), which can shield

your personal assets from business debts and claims

if you plan to raise capital by selling stock to the

public or want to give your employees stock options,

then you should form a corporation

if you’ve considered these issues, then you’ll be

ahead of the game in choosing a legal structure that’s

right for your business Still, you’ll need to consider

the benefits and drawbacks of each type of business

structure before you make your final decision

in all states, the basic types of business structures

to help you pick the best structure for your

business, this chapter explains the basic attributes of

each type

Stephen Parr, owner and director of Oddball

Film and Video, a stock footage company in San

Francisco, California:

What a business really is, is you deciding you

have a business It’s really nothing more than

that.

Making the Decision to Go Official

Some of you may be grappling with a more preliminary question than what legal structure you should choose, and wondering whether or not to formalize your business—to go the official route and register your business with the appropriate agencies

in your state For instance, maybe you’ve been doing freelance graphics work on the side for a number of years, but now you’re thinking of quitting your 9-to-5 job to take on graphics work full-time

Generally speaking, anyone with a good-sized or otherwise visible business should bite the bullet and complete all of the necessary registration tasks to become official Operating under the table can all too easily be exposed, and the government can come after you for fines and penalties, and might even padlock your business, simply for operating without the necessary paperwork And if you’re making

a profit, ignoring the IRS is definitely a bad idea Besides fines and back taxes, you could even face criminal charges and jail time

On the other hand, tiny, home-based, hobby-type businesses can often operate for quite some time without meeting registration requirements If you’re braiding hair or holding an occasional junk sale out

of your garage, for instance, you can probably get by without formal business registration—at least for a while Keep in mind, however, that just because it may be possible doesn’t mean it’s the best option Often, formally registering your business can benefit you, the owner, as well, since you can then write off business expenses and reduce your personal taxes

In Chapter 8, we discuss hobby businesses in more depth, including how tax laws deal with businesses that continually lose money

If you’re not sure whether you want to register your business and open it up to the world of government regulations, the information about registration requirements in this book will put you in

a better position to make a decision Chapter 6 walks you through the many governmental requirements that apply to all new businesses, and explains how

to go about finding and satisfying any additional requirements that may apply to your specific business

this chapter will also help you answer the

most common question new entrepreneurs ask

about choosing a business form: Should i choose

a business structure that offers protection from

personal liability—a corporation or an llc? Here’s a

hint as to what the best advice will be: if you focus

energy and money into getting your business off the

ground as a sole proprietorship or a partnership, you

can always incorporate or form an llc later

Limited Liability

One basic distinction that you’ll probably hear

mentioned lots of times is the difference between

businesses that provide their owners with “limited

liability” and those that don’t Corporations and LLCs

both provide owners with limited personal liability

Sole proprietorships and general partnerships do not

Limited liability basically means that the creditors

of the business cannot normally go after the owners’

personal assets to pay for business debts and claims

arising from lawsuits (Liability for business debts is

discussed in detail later in this chapter.)

As you read about specific business types in

this chapter, you’ll see how a decision to form a

limited liability entity (a corporation or an LLC,

mainly) can dramatically affect how you run your

business On the other hand, sole proprietorships

and partnerships (which are somewhat simpler to

run than corporations and LLCs) may leave an owner

personally vulnerable to business lawsuits and debts

Sole Proprietorships

SKIP AHEAD

Sole proprietorships are one-owner

businesses Any business with two or more owners cannot,

by definition, be a sole proprietorship If you know that

there will be two or more owners of your business, you can

skip ahead to “Partnerships,” below

a sole proprietorship is simply a business that

is owned by one person and that hasn’t filed

papers to become a corporation or an llc Sole proprietorships are easy to set up and to maintain—

so easy that many people own sole proprietorships and don’t even know it for instance, if you are a freelance photographer or writer, a craftsperson who takes jobs on a contract basis, a salesperson who receives only commissions, or an independent contractor who isn’t on an employer’s regular payroll, you are automatically a sole proprietor this is true whether or not you’ve registered your business with your city or obtained any licenses or permits and it makes no difference whether you also have a regular day job as long as you do for-profit work on your own (or sometimes with your spouse—see “running

a business with your Spouse,” below) and have not filed papers to become a corporation or a limited liability company, you are a sole proprietor

CAUTION

Don’t ignore local registration require ments

If you’ve started a business without quite realizing it—for example, you do a little freelance computer programming, which classifies you as a sole proprietor by default—don’t let the fact that you’re technically already a sole proprietor fool you into thinking that you’ve satisfied the governmental requirements for starting a business Most cities and many counties require businesses—even tiny home-based sole proprietor ships—to register with them and pay at least a minimum tax And if you do business under a name different from your own, such as Custom Coding, you usually must register that name—known

as a fictitious business name—with your county In practice, lots of businesses are small enough to get away with ignoring these requirements But if you are caught, you may be subject to back taxes and other penalties (See Chapter 6 for an explanation of how to make the necessary filings with the appropriate government offices.)

Running a Business With Your Spouse

If you plan to start a sole proprietorship and expect

that your spouse may occasionally help out with

business tasks, you should be aware of a fuzzy area in

federal tax law that you can use to your advantage

The IRS typically allows a spouse to pitch in without

pay without risking being classified as an owner or

as an employee of the other spouse’s business This

situation is sometimes erroneously called a

“husband-wife sole proprietorship.”

The normal rule is that someone who does work

for a business must be one of three things from a

legal standpoint: a co-owner, an employee, or an

independent contractor But when that someone is

your spouse, this rule is softened somewhat Your

spouse can volunteer—that is, work without pay—for

your sole proprietorship without being classified as an

employee, freeing the business from paying payroll tax

That saves you money—and, if you have no

other employees, also allows you to avoid the

time-consuming record keeping involved in being an

employer Similarly, a spouse who is not classified as a

partner or an independent contractor won’t have to

pay self-employment taxes, and your business won’t

have to file a partnership tax return

Also consider that under marital property laws that

vary from state to state, if a business is started

or significantly changed when a couple is married, both spouses may have an ownership interest in the business regardless of whose name is on the ownership document

If you are concerned about the possible quences of divorce, read Chapter 14, “Planning for Changes in Ownership.” It discusses how divorce and other life events such as retirement and death can affect ownership of a business and explains how to plan in advance to accommodate the possibilities You may also want to check with a lawyer who is experienced in handling marital property issues to see how your business could be affected in the event of a divorce in your particular state

conse-Finally, if you and your spouse both want to be active partners in a co-owned business—each with

an official say in management—you should create a partnership or an LLC or corporation, even though this will mean filing somewhat more complicated tax returns and other business paperwork If your spouse tries to squeak by as a volunteer in a so-called husband-wife sole proprietorship when you’re really working together as a partnership, you run the risk

of being audited, having the IRS declare you’re a partnership, and socking your spouse with back self-employment taxes

in this section), and the other to personal liability

(explained in the next)

at income tax time, a sole proprietor simply

reports all business income or losses on his or her

individual income tax return the business itself is

not taxed the irS calls this “pass-through” taxation,

because business profits pass through the business

to be taxed on the business owner’s tax return you

report income from a business just like wages from

a job, except that, along with form 1040, you’ll need

to include Schedule c, on which you’ll provide your

business’s profit and loss information One helpful

aspect of this arrangement is that if your business

loses money—and, of course, many start-ups do

in the first year or two—you can use the business

losses to offset any taxable income you have earned

from other sources

exaMPLe: rob has a day job at a coffee shop,

where he earns a modest salary His hobby is

collecting obscure records at thrift stores and

rummage sales contemplating the sad fact that

he has no extra money to spend at the flea

market on Saturday morning, he decides to

start selling some of the vinyl gems he’s found

Still working his day job, he starts a small

business that he calls rob’s revolving records

During his first full year in business, he sees

that a key to consistently selling his records

is developing connections and trust among

record collectors unfortunately, while he is

concentrating on getting to know potential

buyers and others in the business, sales are

slow at year end he closes out his books and

sees that he spent nearly $9,000 on records,

his website, marketing items such as business

cards, and other incidental supplies, while

he made only $3,000 in sales but there is

some good news: rob’s loss of $6,000 can be

counted against his income from his day job,

reducing his taxes and translating into a nice

refund check, which he’ll put right back into

his record business

CAUTION

Your business can’t lose money forever See

the discussion of tax rules for money-losing businesses in Chapter 8

RESOURCE

Be ready for the day you’ll owe taxes Once

your business is underway and turning a profit, you’ll have to start paying taxes (See Chapter 8 for an overview

of the taxes that small businesses face.) Taxes can get fairly complicated, however, and you may need more in-depth guidance For detailed information on taxes for the various types of small businesses, read Tax Savvy for Small Business, by Frederick W Daily (Nolo) This book gives exhaustive information on deductions, record keeping, and audits that will help you reduce your tax bill and stay out of trouble with the IRS

Personal Liability for Business Debts

another crucial thing to know about operating your business as a sole proprietor is that you, as the owner of the business, can be held personally liable for business-related obligations this means that if your business doesn’t pay a supplier, defaults on

a debt, loses a lawsuit, or otherwise finds itself in financial hot water, you, personally, can be forced to pay up this can be a sobering possibility, especially

if you own (or soon hope to own) a cool house, a car, or other treasures personal liability for business obligations stems from the fundamental legal attribute of being a sole proprietor: you and your business are legally one and the same

as explained in more detail in the sections that discuss corporations and llcs, below, the law provides owners of these businesses with “limited personal liability” for business obligations this means that, unlike sole proprietors and general partners, owners of corporations and llcs can normally keep their houses, investments, and other personal property even if their business fails in short, if you are engaged in a risky business, you may want to consider forming a corporation or an llc (although

a thorough insurance policy can protect you from

most lawsuits and claims against the business if your

company is a sole proprietorship or partnership)

CAUTION

Commercial insurance doesn’t cover

business debts Commercial insurance can protect a

business and its owners from some types of liability (for

instance, slip-and-fall lawsuits), but insurance never covers

business debts The only way to limit your personal liability

for business debts is to use a limited liability business

structure such as an LLC or a corporation (or a limited

partnership or limited liability partnership)

Creating a Sole Proprietorship

Setting up a sole proprietorship is incredibly easy

unlike starting an llc or a corporation, you generally

don’t have to file any special forms or pay any special

fees to start working as a sole proprietor you’ll simply

declare your business to be a sole proprietorship

when completing the general registration requirements

that apply to all new businesses, such as getting a

business license from your county or city or a seller’s

permit from your state

for example, when filing for a business tax

registration certificate with your city, you’ll often

be asked to declare what kind of business you’re

starting Some cities require only that you check a

“sole proprietorship” box on a form, while other

cities have separate tax registration forms for sole

proprietorships Similarly, other forms you’ll file,

such as those to register a fictitious business name

and to obtain a seller’s permit, will also ask for this

information (these and other start-up requirements

are discussed in detail in chapter 6.)

Partnerships

bring two or more entrepreneurs together into a

business venture, stir gently, and—poof!—you’ve

got a partnership by definition, a partnership is a

business that has more than one owner and that

has not filed papers with the state to become a

corporation or an llc (or a limited partnership or

limited liability partnership)

CAUTION

Partnerships and registration requirements

Though businesses with two or more owners are partner ships by default, they still must satisfy various governmental requirements for starting a business Most cities and many counties require all businesses to register with them and pay at least a minimum tax And if you do business under a name other than the partners’ names, you usually must register that name—known as a fictitious business name—with your county (See Chapter 6 for an explanation of how to make the necessary filings with the appropriate government offices.)

General Versus Limited Partnerships

usually, when you hear the term “partnership,” it means a general partnership as discussed in more detail below, general partners are personally liable for all business debts, including court judgments

in addition, each individual partner can be sued for the full amount of any business debt (though that partner can turn around and sue the other partners for their share of the debt)

another very important aspect of general ships is that any individual partner can bind the whole business to a contract or business deal—in other words, each partner has “agency authority” for the partnership and remember, each of the partners

partner-is fully personally liable for a business deal gone sour, no matter which partner signed the contract So choose your partners carefully

there are also a couple of special kinds of ner ships, called limited partnerships and limited liability partnerships they operate under very different rules and are relatively uncommon, so they are only briefly described here

part-a limited ppart-artnership requires part-at lepart-ast one generpart-al partner and at least one limited partner the general partner has the same role as in a general partnership:

He or she controls the company’s day-to-day operations and is personally liable for business debts the limited partner contributes financially

to the business (for example, invests $100,000 in

a real estate partnership) but has minimal control over business decisions or operations, and normally cannot bind the partnership to business deals in

return for giving up management power, a limited

partner gets the benefit of protection from personal

liability this means that a limited partner can’t

be forced to pay off business debts or claims with

personal assets, but can lose an investment in the

business but beware: a limited partner who tires of

being passive and starts tinkering under the hood

of the business should understand that his or her

liability can quickly become unlimited that way if a

creditor can prove that the limited partner took acts

that led the creditor to believe that he or she was a

general partner, the limited partner can be held fully

and personally liable for the creditor’s claims

RESOURCE

More on limited partnerships See Form a

Partnership: The Complete Legal Guide, by Denis Clifford

and Ralph Warner (Nolo)

another kind of partnership, called a limited

liability partnership (llp) or sometimes a registered

limited liability partnership (rllp), provides all of its

owners with limited personal liability in some states,

these partnerships are only available to professionals,

such as lawyers and accountants, and are particularly

well suited to them most professionals aren’t keen

on general partnerships, because they don’t want to

be personally liable for another partner’s problems—

particularly those involving malpractice claims

forming a corpo ration to protect personal assets may

be too much trouble, and some states won’t allow

these professionals to form an llc the solution is

often a limited liability partnership this business

structure protects each partner from debts against

the partnership arising from professional malpractice

lawsuits against another partner (a partner who

loses a malpractice suit because of personal

mistakes, however, doesn’t escape liability.)

Pass-Through Taxation

Similar to a sole proprietorship, a partnership

(general or limited) is not a separate tax entity from

its owners; instead, it’s what the irS calls a

“pass-through entity.” this means the partnership itself

does not pay any income taxes; rather, income

passes through the business to each partner, who

pays taxes on a share of profit (or deducts a share

of losses) on an individual income tax return (form 1040, with Schedule E attached) However, the partnership must also file what the irS calls

an “informational return”—form 1065—to let the government know how much the business earned or lost that year no tax is paid with this return—just think of it as the feds’ way of letting you know they’re watching

Personal Liability for Business Debts

Since a partnership is legally inseparable from its owners, just like a sole proprietorship, general partners are personally liable for business-related obligations what’s more, in a general partnership, the business actions of any one partner bind the other partners, who can be held personally liable for those actions So if your business partner takes out an ill-advised high-interest loan on behalf of the partnership, makes a terrible business deal, or gets in some other business mischief without your knowledge, you could be held personally responsible for any debts that result

exaMPLe: Jamie and Kent are partners in

a profitable landscape gardening company they’ve been in business for five years and have earned healthy profits, allowing them each to buy a house, decent wheels, and even

a few luxuries—including Jamie’s collection of garden sculptures and Kent’s roomful of vintage musical instruments One day Jamie, without telling Kent, orders a shipment of exotic poppy plants that he is sure will be a big hit with customers but when the shipment arrives,

so do agents of the federal drug enforcement agency, who confiscate the plants, claiming they could be turned into narcotics Soon thereafter, criminal charges are filed against Jamie and Kent, resulting in several newspaper stories though the partners are ultimately cleared, their attorney fees come to $50,000 and they lose several key accounts, with the result that the business runs up hefty debts as

a general partner, Kent is personally liable for these debts even though he had nothing to do with the ill-fated poppy purchase

before you get too worried about personal

liability, keep in mind that many small businesses

don’t face much of a risk of racking up large

debts for instance, if you’re engaged in a low-risk

enterprise such as freelance editing, landscaping,

or running a small band that plays weddings and

other social events, your risk of facing massive debt

or a huge lawsuit is pretty small for these types of

small, low-risk businesses, a good business insurance

policy that covers most liability risks is almost always

enough to protect owners from a catastrophe like

a lawsuit or fire insurance won’t cover regular

business debts, however if you have significant

personal assets like fat bank accounts or real estate

and plan to rack up some business debt, you may

want to limit your personal liability with a different

business structure, such as an llc or a corporation

Partnership Agreements

by drafting a partnership agreement, you can

structure your relationship with your partners pretty

much however you want you and your partners can

establish the shares of profits (or losses) each partner

will receive, what the responsibilities of each partner

will be, what should happen to the partnership

if a partner leaves, and how a number of other

issues will be handled it is not legally necessary

for a partnership to have a written agreement; the

simple act of two or more people doing business

together creates a partnership but only with a clear

written agreement will all partners be sure of the

important—and sometimes touchy—details of their

business arrangement

in the absence of a partnership agreement,

your state’s version of the uniform partnership act

(upa) or revised uniform partnership act (rupa)

kicks in as a standard, bottom-line guide to the

rights and responsibilities of each partner most

states have adopted the upa or rupa in some

form in california, for example, if you don’t have a

partnership agreement, then california’s rupa states

that each partner has an equal share in the business’s

profits, losses, and management power Similarly,

unless you provide otherwise in a written agreement,

a california partnership won’t be able to add a

new partner without the unanimous consent of all

partners (cal corp code § 16401.)

in short, it’s important to understand that you can override many of the legal provisions contained in the upa or rupa if you and your partners have your own written agreement

in a separate document or may be included in partnership agreements or other organizational documents depending

on the company structure: operating agreements for LLCs,

or bylaws for corporations Read Chapter 14 to become familiar with the ownership issues that can arise when your business is owned by more than one person—and how best to head off problems with a solid agreement

What a Partnership Agreement Can’t Do

Although a general partnership agreement is an incredibly flexible tool for defining the ownership interests, work responsibilities, and other rights of partners, there are some things it can’t do These include:

• freeing the partners from personal liability for business debts

• restricting any partner’s right to inspect the business books and records

• affecting the rights of third parties in relation

to the partnership—for example, a ship agreement that says a partner has no right to sign contracts won’t affect the rights

partner-of an outsider who signs a contract with that partner, and

• eliminating or weakening the duty of trust (the fiduciary duty) each partner owes to the other partners

there’s nothing terribly complex about drafting

partnership agreements they’re usually only a

few pages long and cover basic issues that you’ve

probably thought over to some degree already

partnership agreements typically include at least the

these and any other terms you include in a

partnership agreement can be dealt with in more

or less detail Some partnership agreements cover

each topic with a sentence or two; others spend

up to a few pages on each provision you need

an agreement that’s appropriate for the size and

formality of your business, but it’s not a good idea to

skimp on your partnership agreement

RESOURCE

For more on partnerships Form a Partner­ ship: The Complete Legal Guide , by Denis Clifford and

Ralph Warner (Nolo), is an excellent step-by-step guide

to putting together a solid, comprehensive partnership agreement Also, Business Buyout Agreements: A Step­ by­Step Guide for Co­Owners , by Anthony Mancuso and

Bethany Laurence (Nolo), explains how to draft terms that will enable you to deal with business ownership transitions If you think you may want more than the simple partnership agreements in this book but don’t want to spend a lot of time creating an agreement, there are more detailed partnership agreement forms (as well as many other resources for running your small business) on the CD in Quicken Legal Business Pro 2010 (Nolo) You can learn more about these resources at www.nolo.com take a look at the short sample partnership agree-ments on the following pages to see how a very basic partnership agreement can be put together (you’ll also find a blank partnership agreement in appendix c and on the cD-rOm that comes with this book.) these samples are about as basic as it gets—the bare minimum—and you’ll almost surely want to use something more detailed for your business

Partnership Agreement #1

Alison Shanley and Peder Johnson make the following partnership agreement

Name and Purpose of Partnership

As of September 22, 20xx, Alison and Peder are the sole owners and partners of the Vermont Fly-Fishing Company The Vermont Fly-Fishing Company shall be headquartered in Rutland, Vermont, and will sell fly-fishing equipment by mail order

Contributions to the Partnership

Alison and Peder will make the following contributions to the partnership:

Alison Shanley cash $10,000

desk, miscellaneous office furniture 1,000Total contribution: $11,000Peder Johnson cash $7,000

computer system 2,000Total contribution: $9,000

Profit and Loss allocation

Alison and Peder will share business profits and losses in the same proportions as their contributions to the business

Management of Partnership Business

Alison and Peder will have equal management powers and responsibilities

Departure of a Partner

If either Alison or Peder leaves the partnership for any reason, including voluntary withdrawal, expulsion,

or death, the remaining partner shall become the sole owner of the Vermont Fly-Fishing Company, which shall become a sole proprietorship The remaining owner shall pay the departing partner, or the deceased departing partner’s estate, the fair market value of the departing partner’s share of the business as of the date of his or her departure The partnership’s accountant shall determine the fair market value of the departing partner’s share of the business according to the partnership’s book value

Mediation of Disputes

Alison and Peder agree to mediate any dispute arising under this agreement with a mutually acceptable mediator

amendment of agreement

This agreement may not be amended without the written consent of both partners

Alison Shanley Peder Johnson

Signature Signature

Social Security # Social Security #

Partnership Agreement #2

Christine Wenc, Simon Romero, and Brendan Doherty agree to the terms of the following agreement

1 Name of Partnership Christine, Simon, and Brendan are partners in the Wenc & Romero

Partnership They created the partnership on July 12, 20xx

2 Partnership Purpose The Wenc & Romero Partnership will provide newspaper clipping

services to clients

3 Contributions to the Partnership Christine, Simon, and Brendan will contribute the following

to the partnership:

Christine: $1,000 cash; one Macintosh computer (value $1,500); and one monitor (value $500)

Simon: $1,000 cash; one fax machine (value $400); one laser printer (value $1,200)

Brendan: $500 cash; various office equipment (value $500)

4 Profits and Losses Christine, Simon, and Brendan shall share profits and losses as follows:

No partner may accept a new client without the agreement of the others

6 additional Terms to Be Drafted Christine, Simon, and Brendan agree that in six months they

will sign a formal partnership agreement which covers the items in this agreement in more

detail, and the additional following items:

• each partner’s work contributions

• provisions for adding a partner

• provisions for the departure of a partner, and

• provisions for selling the business

7 amendments This agreement may not be amended without the written consent of all partners.

Limited Liability

Companies (LLCs)

like many business owners just starting out, you

might find yourself in this common quandary: On

one hand, having to cope with the risk of personal

liability for business misfortunes scares you; on the

other, you would rather not deal with the red tape

of starting and operating a corporation fortunately

for you and many other entrepreneurs, you can

avoid these problems by taking advantage of a

relatively new form of business called the limited

liability company, commonly known as an llc

llcs combine the pass-through taxation of a sole

proprietorship or partnership (taxes on business

income are paid on each owner’s individual income

tax returns) with the same protection against

personal liability that corporations offer

CAUTION

Beware of special state rules For example,

California prohibits licensed professionals from organizing

as an LLC (but not as a professional corporation or limited

partnership) Some other states have extra LLC formalities

for licensed professionals, which you can discover by

asking your state licensing board

Limited Personal Liability

generally speaking, owners of an llc (called

“members”) are not personally liable for the llc’s

debts (there are some exceptions to this rule,

discussed below.) this protects the members from

legal and financial liability in case their business

fails, or loses a lawsuit, and can’t pay its debts in

those situations, creditors can take all of the llc’s

assets, but they generally can’t get at the personal

assets of the llc’s members losing your business

is no picnic, but it’s a lot better to lose only what

you put into the business than to say goodbye to

everything you own

exaMPLe: callie forms her own one-person

mail-order business, using most of her $25,000

in savings to establish a professional website

and buy mailing lists callie realizes that she’ll

have to buy a significant portion of her sales inventory up front to be able to ship goods

to her customers on time, so she plans to buy those items on credit while she is willing

to risk her $25,000 investment to pursue her dream, she is worried that if her mail-order business fails, she will be buried under a pile

of debt callie decides to form an llc so that

if her business should fail, she’ll only lose the $25,000; no one will be able to sue her personally for the business debt that she owes She feels more secure going into business knowing that even if her business fails, she can walk away without the risk of losing her house

or her car

while some llcs opt for a structure in which the company is run by specially designated managers, most llcs are simply managed by the members this more common setup is called a “member-managed” llc; one that is run by managers (who are elected

by the members) is called a “manager-managed” llc a manager-managed llc might be appropriate

if some of the llc’s owners are passive investors (similar to limited partners), while a smaller group intends to actively run the company if all the llc owners intend to actively manage the company, you’ll generally use the more common member-managed structure

with this in mind, remember that, like a general partner in a partnership, any member of a member-managed llc can legally bind the entire llc to a contract or business transaction in other words, each member can act as an agent of the llc in manager-managed llcs, any manager can bind the llc to a business contract or deal

while llc owners enjoy limited personal liability for many of their business debts, this protection is not absolute there are several situations in which

an llc owner may become personally liable for business debts or claims However, this drawback is not unique to llcs—the limited liability protection given to llc members is just as strong as (if not stronger than) that enjoyed by the corporate shareholders of small corporations Here are the main situations where llc owners can still be held personally liable for debts:

• Personal guarantees if you give a personal

guarantee on a loan to the llc, then you are

personally liable for repaying that loan because

personal guarantees are often required by

banks and other lenders, this is a good reason

to be a conservative borrower Of course, if

no personal guarantee is made, then only the

llc—not the members—is liable for the debt

• Taxes the irS or the state tax agency may go

after the personal assets of llc owners for

overdue federal and state business tax debts,

particularly overdue payroll taxes this is most

likely to happen to members of small llcs

who have an active hand in managing the

business, rather than to passive members

• Negligent or intentional acts an llc owner

who intentionally or even carelessly hurts

someone will usually face personal liability

for example, if an llc owner takes a client to

lunch, has a few martinis, and injures the client

in a car accident on the way home, the llc

owner can be held personally liable for the

client’s injuries

• Breach of fiduciary duty llc owners have

a legal duty to act in the best interest of

their company and its members this legal

obligation is known as a “fiduciary duty,” or

is sometimes simply called a “duty of care.”

an llc owner who violates this duty can be

held personally liable for any damages that

result from the owner’s actions (or inactions)

fortunately for llc owners, they normally

will not be held personally responsible for any

honest mistakes or acts of poor judgment they

commit in doing their jobs most often, breach

of duty is found only for serious indiscretions

such as fraud or other illegal behavior

• Blurring the boundaries between the LLC and

its owners when owners fail to respect the

separate legal existence of their llc, but instead

treat it as an extension of their personal affairs,

a court may ignore the existence of the llc and

rule that the owners are personally liable for

business debts and liabilities generally, this is

more likely to occur in one-member llcs; in

reality, it only happens in extreme cases you

can easily avoid it by opening a separate llc

checking account, getting a federal employer identification number, keeping separate accounting books for your llc, and funding your llc adequately enough to be able to meet foreseeable expenses

LLC Taxation

like a sole proprietorship or a partnership, an llc is not a separate tax entity from its owners; instead, it’s what the irS calls a “pass-through entity.” this means the llc itself does not pay any income taxes; instead, income passes through the business to each llc owner, who pays taxes on the share of profit (or deducts the share of losses) on the owner’s individual income tax return (for the feds, form 1040 with Schedule E attached) but a multiowned llc, like a partnership, does have to file form 1065—an

“informational return”—to let the government know how much the business earned or lost that year no tax is paid with this return

llcs give members the flexibility to choose to have the company taxed like a corporation rather than as a pass-through entity in fact, partnerships now have this option as well (See chapter 8 for more about taxes.)

you may wonder why llc owners would choose

to be taxed as a corporation after all, pass-through taxation is one of the most popular features of an llc the answer is that, because of the income-splitting strategy of corporations (discussed in “corporate taxation,” below), llc members can sometimes come out ahead by having their business taxed as a separate entity at corporate tax rates

for example, if the owners of an llc become successful enough to keep some profits in the business at the end of the year (or regularly need to keep significant profits in the business for upcoming expenses), paying tax at corporate tax rates can save them money that’s because federal income tax rates for corporations start at a lower rate than the rates for individuals for this reason, many llcs start out being taxed as partnerships, and when they make enough profit to justify keeping some in the business (rather than doling it out as salaries and bonuses), they opt for corporate-style taxation

LLCs Versus S Corporations

before llcs came along, the only way all owners

of a business could get limited personal liability

was to form a corporation problem was, many

entrepreneurs didn’t want the hassle and expense

of incorporating, not to mention the headache of

dealing with corporate taxation One easier option

was to form a special type of corporation known as

an S corporation, which is like a normal corporation

in most respects, except that business profits pass

through to the owner (as in a sole proprietorship

or partnership), rather than being taxed to the

corporation at corporate tax rates in other words,

S corporations offered the limited liability of a

corporation with the pass-through taxation of a

sole proprietorship or partnership for a long time,

this was an okay compromise for

small-to-medium-sized businesses, though they still had to deal with

requirements of running an S corporation (discussed

in more detail below)

now, however, llcs offer a better option llcs are

indeed similar to S corporations in that they combine

limited personal liability with pass-through tax

status but a significant difference between these two

types of businesses is that llcs are not bound by the

many regulations that govern S corporations

Here’s a quick rundown of the major areas of

difference between S corporations and llcs (Keep

in mind that corporations, including S corporations,

are explained in more detail in the next section.)

• Ownership restrictions an S corporation may

not have more than 75 shareholders, all of

whom must be u.S citizens or residents

this means that some of the c corporation’s

main benefits—namely, the ability to set up

stock option and bonus plans and to bring

in public capital—are pretty much out of the

question for S corporations and even if an S

corporation initially meets the u.S citizen or

resident requirement, its shareholders can’t sell

shares to another company (like a corporation

or an llc) or a foreign citizen, on pain of

losing S corporation tax status in an llc,

any type of person or entity can become a

member—a u.S citizen, a citizen of a foreign

country, another llc, a corporation, or a

limited partnership

• Allocation of profits and losses Shareholders

of an S corporation must allocate profits according to the percentage of stock each owner has for example, a 25% owner has to receive 25% of the profits (or losses), even if the owners want a different division Owners

of an llc, on the other hand, may distribute profits (and the tax burden that goes with them) however they see fit, without regard

to each member’s ownership share in the company for instance, a member of an llc who owns 25% of the business can receive 50% of the profits if the other members agree (subject to a few irS rules)

• Corporate meeting and record-keeping rules

for S corporation shareholders to keep their limited liability protection, they have to follow the corporate rules: issuing stock, electing officers, holding regular board of directors’ and shareholders’ meetings, keeping corporate minutes of all meetings, and following

the mandatory rules found in their state’s corporation code by contrast, llc owners don’t need to jump through most of these legal hoops—they just have to make sure their management team is in agreement on major decisions and go about their business

• Tax treatment of losses S corporation

shareholders are at a disadvantage if their company goes into substantial debt—for instance, if it borrows money to open the business or buy real estate that’s because

an S corporation’s business debt cannot be passed along to its shareholders unless they have personally cosigned and guaranteed the debt llc owners, on the other hand, normally can reap the tax benefits of any business debt, cosigned or not this can translate into a nice tax break for owners of llcs that carry debt

Forming an LLC

to form an llc, you must file articles of tion with your Secretary of State or other llc filing office you should also execute an operating agree-ment, which governs the internal workings of your llc before you decide the llc is the best thing since easy cheese, you should be aware that an llc

Organiza-might not be as cheap to start as a partnership or

sole proprietorship a few states charge significant

filing fees, plus annual dues (alternately called

mini-mum taxes, annual fees, or renewal fees) these

fees can push the costs of starting an llc into the

several-hundred-dollar range illinois, for instance,

charges a $500 filing fee, and california requires that

you pay a minimum annual llc tax of $800 when

you start your llc—on top of its $70 filing fee

many brand-new business owners aren’t in a

position to pay this kind of money right out of the

starting gate, so they start out as partnerships until

they bring in enough income to cover these costs

and if you’re thinking of forming a corporation

instead, keep in mind that most states charge at

least as much in fees for corporations this plus the

added expenses of running a corporation (legal and

accounting fees, for example) will almost always

make a corporation more expensive to run than

an llc

CAUTION

Some LLCs must comply with securities

laws LLCs that have owners who do not actively

participate in the business may have to register their

membership interests as securities or, more likely, qualify

for an exemption to the registration requirements For

information about exemptions to the federal securities

laws, visit the Securities and Exchange Commission’s

website at www.sec.gov and click “Information for Small

Business.”

RESOURCE

For more on LLCs Your Secretary of State

or other LLC filing office will have lots of information on

LLC rules and procedures in your state To find yours,

see the list of LLC Offices included in Appendix A and

on the CD-ROM that comes with this book Form Your

Own Limited Liability Company, by Anthony Mancuso

(Nolo), gives detailed information on LLCs, including

step-by-step instructions and forms for creating one

For a briefer treatment, consult Nolo’s Quick LLC: All You

Need to Know About Limited Liability Companies, also by

Anthony Mancuso It offers an overview of LLCs as well

as comparisons to other business structures, but does

not include any start-up forms Nolo also offers an online application and LLC software to form your LLC online (see www.nolo.com for details)

a corporation can be as large as ibm or, in many cases, as small as one person

One fundamental legal characteristic of a corporation is that it’s a separate legal entity from its owners if you’ve already read this chapter’s sections on sole proprietorships and partnerships, you’ll recognize that this is a major difference between those unincorporated business types and corporations another important corporate feature

is that shareholders are normally protected from personal liability for business debts finally, the corporation itself—not just the shareholders—is subject to income tax

is heavily regulated by state and federal securities laws, while corporations that sell shares, without advertising, only to a select group of people who meet specific state requirements are often exempt from many of these laws

If you plan to sell shares of a corporation to the general public, you should consult a lawyer

Limited Personal Liability

generally speaking, owners of a corporation are

not personally liable for the corporation’s debts

(there are some exceptions to this rule, discussed

below.) limited personal liability is a major reason

why owners have traditionally chosen to incorporate

their businesses: to protect themselves from legal

and financial liability in case their business flounders

or loses an expensive lawsuit and can’t pay its

debts in those situations, creditors can take all of

the corporation’s assets (including the shareholders’

investments), but they generally can’t get at the

personal assets of the shareholders

exaMPLe: tim and chris publish Tropics

Tripping, a monthly travel magazine with a

focus on latin america because they both

have significant personal assets, and because

they will have to borrow a lot of capital to start

up their magazine, they form their business as

a corporation to protect their personal assets

in case their magazine fails they do great for

a few years, but suddenly their subscription

and advertising revenue starts to suffer when a

recession plus political unrest in several latin

american countries reduces interest in travel to

that area Hoping the situation will turn itself

around, tim and chris forge ahead—and go

deeper into debt as it proves impossible to pay

printing and other bills on time finally, when

their printer won’t do any more print runs

on credit, tim and chris are forced to call it

quits Tropics Tripping’s debts total $250,000,

while business assets are valued at only

$90,000—leaving a $160,000 debt to creditors

thankfully for tim and chris, they won’t

have to use their personal assets to pay the

$160,000, because, as owners of a corporation,

they’re shielded from personal liability

TIP

Corporations aren’t the only option With

the advent of limited liability companies, corporations

aren’t the only business entities that provide limited

liability status for all owners (See the section on LLCs,

above.)

forming a corporation to shield yourself from personal liability for business obligations provides good, but not complete, protection for your personal assets Here are the principal areas in which

corporation owners still face personal liability:

• Personal guarantees if you give a personal

guarantee on a loan to the corporation, then you are personally liable for the repayment

of that loan because lenders often require a personal guarantee, this is a good reason to

be a conservative borrower Of course, if no personal guarantee is made, then only the corporation—not the shareholders—is liable for the debt

• Taxes the irS or the state’s tax agency may go

after the personal assets of corporate owners for overdue corporate federal and state tax debts, particularly overdue payroll taxes this

is most likely to happen to owners of small corporations who have an active hand in managing the business, rather than to passive shareholders

• Negligent or intentional acts a corporate

owner who is negligent (that is, careless)

or perhaps even intentional, and ends up hurting someone, can’t hide behind the corporate barrier to escape personal liability Shareholders are subject to personal liability for wrongs they commit—such as attacking a customer or leaving a floor wet in a store—that result in injury

• Breach of fiduciary duty corporate owners

have a legal duty to act in the best interest of the company and its shareholders this legal obligation is known as a “fiduciary duty,” sometimes simply called a “duty of care.” if

an owner violates this duty, the owner can be held personally liable for any damages that result from his or her actions (or inactions) fortunately for corporate owners, run-of-the-mill mistakes or lapses in judgment aren’t usually considered breaches of the duty of care most often, breach of duty is found only for serious indiscretions such as fraud or other illegal behavior for example, if a corporate officer ignored repeated warnings and written reports that one of its manufacturers was using

toxic ingredients in the pet products sold by

the corporation, that officer could be held

personally liable for any damages that result

from that breach of duty to the company

• Blurring the boundaries between the corporation

and its owners when corporate owners ignore

corporate formalities and treat the corporation

like an unincorporated business, a court may

ignore the existence of the corporation (in

legal slang, “pierce the corporate veil”) and

rule that the owners are personally liable for

business debts and liabilities to avoid this,

it’s important that corporate owners not allow

the legal boundary between the corporation

and its owners to grow fuzzy Owners need to

scrupulously respect corporate formalities by

holding shareholders’ and directors’ meetings,

keeping attentive minutes, issuing stock

certificates, and maintaining corporate accounts

strictly separate from personal funds

also, bear in mind that while limited personal

liability can prevent you from losing your home,

car, bank account, and other assets, it won’t

protect you from losing your investment in your

business a business can quickly get wiped out if a

customer, employee, or supplier wins a big lawsuit

against it and the business has to be liquidated to

cover the debt in short, even if you incorporate to

protect your personal assets, you should purchase

appropriate insurance to protect your business

assets (insurance is discussed in chapter 7.) but

remember, insurance won’t help if you simply can’t

pay your normal business debts

Corporate Taxation

the words “corporate taxes” raise a lot of fear and

loathing in the business world fortunately, the

reality of corporate taxation is usually less depressing

than its reputation Here are the basics—think of it

as corporate tax lite if you decide to incorporate,

you’ll likely want to consult an accountant or small

business lawyer who can fill you in on the fine

print (See chapter 16 for information on finding and

hiring a lawyer.)

the first thing you need to know is that you’ll be treated differently for tax purposes depending on whether you operate as a regular corporation (also called a c corporation) or you elect S corporation status for tax purposes an S corporation is the same as a c corporation in most respects, but when it comes to taxes, c and S corporations are very different animals a regular, or c, corporation must pay taxes, while an S corporation is treated like a partnership for tax purposes and doesn’t pay any income taxes itself like partnership profits, S corporation profits (and losses) pass through to the shareholders, who report them on their individual returns (in this respect, S corporations are very similar to llcs, which also offer limited liability, along with partnership-style tax treatment.) these two types of corporations are explained in more detail just below

C Corporations

as a separate tax entity, a regular corporation must file and pay income taxes on its own tax return, much like an individual does after deductions for such things as employee compensation, fringe benefits, and all other reasonable and necessary business expenses have been subtracted from its earnings, a corporation pays tax on whatever profit remains

in small corporations in which all of the owners

of the business are also employees, all of the corporation’s profits are often paid out in tax-deductible salaries and fringe benefits—leaving no corporate profit and, thus, no corporate taxes due (the owner/employees must, of course, pay income tax on their salaries on their individual returns.)

Fringes and Perks

Like employee salaries, corporations can deduct many

fringe benefits as business expenses If a corporation

pays for benefits such as health and disability

insurance for its employees and owner/employees,

the cost can usually be deducted from the corporate

income, reducing a possible tax bill (There’s one main

exception: Benefits given to an owner/employee of an

S corporation who owns 2% or more of the stock can’t

be deducted as business expenses.)

As a general rule, owners of sole proprietorships,

partner ships, and LLCs can deduct the cost of

provid ing these benefits for employees, but not for

themselves (These owners can, however, deduct a

portion of their medical insurance premiums, though

it’s technically a deduction for the individuals, not a

business expense.)

The fact that fringe benefits for owners are

deductible for corporations may make incorporating

a wise choice But it’s less likely to be a winning

strategy for a capital-poor start-up that can’t afford

to underwrite a benefits package

initial rates of corporate taxation are comparatively

low (see “marginal tax rates for corporations,”

below) corporations that keep some profits in the

business from one year to the next—rather than

paying out all profits as salaries and bonuses—can

take advantage of 15% to 25% tax brackets this

practice, sometimes called income-splitting, basically

involves strategically setting salaries at a level so

that money left in the business is taxable only at

the 15% or 25% corporate tax rate (which applies to

profits up to $50,000 or $75,000) Since any amount

of “reasonable” compensation to employees is

deductible, corporate owners have lots of leeway in

setting salaries to accomplish this

Marginal Tax Rates for Corporations

The following chart shows tax rates for corporations For example, if a corporation’s taxable income was $75,100, it would pay 15% of its first $50,000

of income, 25% of the next $25,000, and 34% on its remaining $100 in income The corporation’s marginal tax rate—the tax rate a corporation would pay on the last dollar of its income—would be 34%

Taxable Income Tax rate

Note: These corporate rates don’t apply to

profes-sional corporations, which are subject to a flat tax of 35% on all corporate income

exaMPLe: alexis and matt run window to the past, inc., a glass manufacturing business that specializes in custom work for architectural renovations toward the end of the year, they calculate that year’s profit to be approximately

$145,000 they decide to give themselves each

a $50,000 bonus out of the profit (on top of their $40,000 salaries) because both salaries and bonuses are tax-deductible business expenses, this reduces window to the past’s taxable income to $45,000 the resulting corporate profit of $45,000 will be taxed at only 15%, the lowest rate (if alexis and matt had left all the profits in the business, the profits over $75,000 would have been taxed

at 34%, and profits over $100,000 would have been taxed at a whopping 39%.) Of course, the bonuses alexis and matt give themselves increase their personal income, which will be

taxed on their individual returns Still, their

personal tax rates are lower than the high

corporate rates of 34% and 39%

this income-splitting strategy is available only

to shareholders who also work for the corporation

if they’re not at least part-time employees, then

shareholders won’t be in a position to earn salaries

or bonuses and will be able to take money from the

corporation only as dividends

Double Taxation

this brings us to the vexing problem of double

taxation, routinely faced by larger corporations with

shareholders who aren’t active employees unlike

salaries and bonuses, dividends paid to shareholders

cannot be deducted as business expenses from

corporate earnings because they’re not deducted,

any amounts paid as dividends are included in the

total corporate profit and taxed and when the

shareholder receives the dividend, it is taxed at the

shareholder’s individual tax rate as part of personal

income as you can see, any money paid out as a

dividend gets taxed twice: once at the corporate

level, and once at the individual level

you can avoid double taxation simply by

not paying dividends this is usually easy if all

shareholders are employees, but probably more

difficult if some shareholders are passive investors

anxious for a reasonable return on their investments

S Corporations

unlike a regular corporation, an S corporation does

not pay taxes itself any profits pass through to the

owners, who pay taxes on income as if the business

were a sole proprietorship, a partnership, or an llc

yet the business is still a corporation this means, of

course, that its owners are protected from personal

liability for business debts, just as shareholders of

c corporations and members (owners) of llcs are

until the relatively recent arrival of the llc

(discussed above), the S corporation was the

business form of choice for those who wanted

limited liability protection without the two-tiered tax

structure of a c corporation today, relatively few

businesses are organized as S corporations, because

S corporations are subject to many regulations that do

not apply to llcs (See “llcs Versus S corporations,” above, for more information)

Forming and Running a Corporation

in addition to tax complexity, major drawbacks to forming a corporation—either a c or an S type—are time and expense unlike with sole proprietorships and partnerships, you can’t clap your hands twice and conjure up a corporation to incorporate, you must file articles of incorporation with your Secretary of State or other corporate filing office, along with often hefty filing fees and minimum annual taxes and if you decide to sell shares of the corporation to the public—as opposed to keeping them in the hands of a relatively small number of owners—you’ll have to comply with lots of complex federal and state securities laws

finally, to protect your limited personal liability, you need to act like a corporation, which means adopting bylaws, issuing stock to shareholders, main-taining records of various meetings of directors and shareholders, and keeping records and transactions of the business separate from those of the owners

to sum up, the protection afforded by ing comes at a price figure in the likelihood that you’ll have to hire lawyers, accountants, and other professionals to keep your corporation in compliance, and it’s easy to see how expensive running a corpo-ration can be

incorporat-RESOURCE

Recommended reading on corporations For

more information on the many complexities of running a corporation, read The Corporate Records Handbook: Meet­ ings, Minutes & Resolutions , by Anthony Mancuso (Nolo).